Prices and Markets Session 8 Implicit Price Discrimination Prof. - PDF document

New Baldness Drug Is an Older Product at a Premium Price What is this an example of? Given Merck � s pricing strategy for which market is demand more inelastic? Is the baldness market really more inelastic than the prostrate market? Can you detect the fallacy of sunk costs? Prices and Markets Session 8 Implicit Price Discrimination Prof. Amine Ouazad

Recap: Perfect Price Discrimination High valuation P P customers Lower valuation customers Op5mal# price# Variable#profit# Variable# “No$money$is$le,$ profit# on$the$table”$ MC# MC# Demand# Demand# MR# Q Q Uniform'Pricing' Perfect'Price'Discrimina.on' “A key step is to avoid uniform pricing. Pricing to specific customer groups should reflect the true competitive value of what is being provided. No money is left on the table...” A. Miles, Pricing , Boston Consulting Group. Theme of today � s class: How Economists Hunt Elephants? ECONOMISTS don't hunt elephants, but believe that if elephants are given sufficient incentives, they will hunt themselves .

This Session Implicit Price Discrimination 1. Implicit Price Discrimination 2. Airline pricing 3. Bundling Next Session Perfect Competition Last 2 Sessions Uniform Pricing (One Price for All) Explicit Market Segmentation (Different Prices for Different People) This Session – Implicit Market Segmentation (Screening) – (Different Choices for Different People) A Classic Pricing Dilemma: You know composition of market, but cannot identify valuation of individual customers.

How to Get Elephants to Hunt Themselves Cappuccino for high WTP: £2 Cappuccino for low WTP: £1 Cappuccino (no frills) 1.85 Hot Chocolate (no frills) 1.89 Café Mocha (mix them together – I am special) 2.05 White Chocolate Mocha (use different powder – I am really special) 2.49 White Chocolate Mocha Venti (I am greedy) 3.09 Fair Trade Coffee at Costa Coffee Cappuccino for the concerned: £1.85 Cappuccino for the unconcerned: £1.75 Premium paid to farmers in Guatemala: 50p per pound of coffee beans On a cappuccino that translates to a cost increase of less then a penny a cup � The Elusive Short Cappuccino at Starbucks � A 20 oz cappuccino is an oxymoron A Requisite for Screening Options cannot differ only by price; you need another dimension or product characteristic about which customers have different preferences. • Called: � Screening Mechanism � • Must be correlated with willingness to pay Real World Examples: 1. Product differentiation Coffee pricing, Airline pricing This session 2. Bundling Cable TV channels This session

Basic Terms and Concepts Menu The set of options you offer your customers. Objective Customize trades in the menu such that high valuation consumers freely choose the more expensive option on the menu. Make sure menu satisfies two constraints: Participation constraint Customer prefers the deal over not trading at all. Self-selection constraint Customer prefers the deal you have designed for him/ her over other deals in menu. A Simple Example: Coupons Coupons and mail-in rebates require an effort on the part of the consumer to redeem (usually, must be mailed in for refund) Coupons and rebates – a rather expensive way to cut prices ! Coupons must be printed and circulated ! Redeeming them is expensive: applications must be processed, checks cut and mailed So why issue coupons? Why not just cut prices?

Coupons An Alternative Explanation ! Consumers are not equally likely to redeem coupons ! Correlation between a consumer � s willingness to pay and the likelihood that he/she redeems What is the likely direction of this correlation? ! Rebates discriminate among consumers according to the opportunity cost of their time ! ...and for this to work it is essential that redemption is made to be a time-consuming hassle

Coupons As a Screening Device Without rebates, P 0 may be optimal because the firm gives up A+B to sell additional output so MR = C – A – B . P ($) With rebates, only some consumer redeem, so Demand MR = C – A , and a price cut is more attractive. Note that here there are effectively two prices in the market. Old price: P 0 B A New price: P 1 don � t C redeem redeem Q Q 0 Q 0 +1 Price Elasticity of Demand for Users Vs. Nonusers of Coupons Price Elasticity Product Nonusers Users Cat food 0.49 1.13 Frozen entrée 0.60 0.95 Gelatin 0.97 1.25 Spaghetti sauce 1.65 1.81 Shampoo/conditioner 0.82 1.12 Soup 1.05 1.22 Hot dogs 0.59 0.77 Cooking oil 1.21 1.32

Other Examples of Implicit Price Discrimination Hardcover vs. Softcover Books Versioning/Damaging Home Premium Professional Ultimate Happy hour; Outlet malls 214.99 319.99 337.99 Super Thursday: Regular Thursday sales in supermarkets Damaged Goods: • IBM laser printers; Mathematica student version; Intel processors • Federal Express offers both morning and afternoon delivery. FedEx does not deliver afternoon packages in the morning, even if they arrive in time for morning delivery. Instead they will make two trips to the same location. Ingenious Price Discrimination Metro Getaways: http://metro.driveline.co.uk/ Two-night break in Madrid on 4th August 2006, with flights from London Hotel Price Price (Lowest First) (Highest First) Francisco 1 Hotel £146.80 £169.50 Asturias Hotel £147.65 £170.35 Tryp Washington £174.00 £196.70 Tryp Rex £174.00 £196.70 Tryp Menfis £184.20 £206.90 Tryp Ambassador £189.30 £212.00 Vincci Soho £192.70 £215.40 Gran Melia Fenix £257.30 £280.00 Actual quotes for tickets on Feb 27, 04: 1. Minneapolis-Newark: go: Wed, March 20, return: Fri, March 22: $772.50 2. Minneapolis-Newark: go: Wed, March 20, return: Wed, March 27: $226.50 3. Newark-Minneapolis: go: Fri, March 22, return: Wed, March 27: $246.50

This Session Implicit Price Discrimination 1. Implicit Price Discrimination 2. Airline pricing 3. Bundling Next Session Perfect Competition The Mother of All Discriminatory Pricing: Airline Pricing Airlines like to segment the market based on valuations, but valuations are not observed ! On the other hand, valuations are correlated with time sensitivity ! In general consumers with higher valuation are less likely to accept: • Saturday night stay • A 14-day advance ticketing ,..etc. ! Solution: Create a product line based on artificial restrictions. These simply annoy the customers, and have little or no bearing on their cost of operation

Screening with Differentiated Products Scenario: Airline has B business customers and L leisure customers. Valuation Type of Customer Unrestricted Restricted Business $1000 $600 Leisure $600 $500 Cost per ticket = $ 300 (Same for restricted and unrestricted tickets) – Explicit Market Segmentation?? – Pricing of Only Unrestricted Tickets Option 1 : Charge $1000 and sell only to Business travelers Profit = (1000-300)*B = 700B Option 2: Charge $600 and sell to both Business and Leisure Profit = (600-300)*(B + L) = 300 (B + L)

Screening with Restricted & Unrestricted Tickets Option 3 : Charge $900 and sell unrestricted tickets to Business travelers Charge $500 and sell restricted tickets to Leisure travelers Profit = (900-300)*B + (500-300)L = 600B + 200L This is Screening or Implicit Market Segmentation Comparison of 3 Options (A) sell only unrestricted tickets at a price of ___________ to business travelers only; Profit: (B) sell only unrestricted tickets at a price of ____________ to all travelers; Profit: (C) sell unrestricted tickets to business travelers for ____________ and restricted tickets to leisure travelers for __________. Profit:

Profit 60000 A 50000 C 40000 30000 B 20000 10000 % Bus. Travelers ( B ) 0 0 10 20 30 40 50 60 70 80 90 100 A Best B Best C Best Wrap Up • Even if you cannot explicitly segment the market don � t lose heart – implicitly segment the market! • Offer a menu of options and try to come up with a creative screening mechanism • Try product differentiation, versioning, inter-temporal pricing, damaging, bundling (see this next time) – these achieve price discrimination

Bottom Line Marketing guru says: � the right product for the right customer at the right price, � Economist sage says: � segment, differentiate, then segment some more!! � 1. Find products where you can effectively prevent high-end consumers from buying the low-end product 2. If you can � t, implicitly segment the market – design a product line through bundling, differentiation, versioning, inter-temporal pricing, damaging that achieves price discrimination Do not ignore the composition of your market!

This Session Implicit Price Discrimination 1. Implicit Price Discrimination 2. Airline pricing 3. Bundling Next Session Perfect Competition Bundling • Selling several goods in one bundle " Hardware and software " Software suites " Sports/Concert tickets " Auto accessories

Exercise 6.6: Screening via Bundling Pricing of the polo shirt and the dinner party at the Lebanese week. Highly segmented, with only three types of customers: Valuation Type of Customer Polo Shirt Dinner A $50 $5 B $40 $40 C $5 $50 A customer may buy either the polo shirt or the dinner. – Benchmark: Perfect Price Discrimination – – No Bundling –